If you scan through the offerings of fund managers, including those who favour direct equities, it won't be long before you come across what is referred to as a "Value" fund or approach. So what is a value investment approach and how can it be successfully used within investment portfolios?
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The idea behind a "value" approach to investing is that companies that currently seem out of favour with the market will provide a higher return going forward. In 1987 Michelle Clayman published a study in the Journal of Finance (Volume 63, May-June). The article looked at the performance of a group of 29 "excellent" companies - using the criteria for an excellent company as identified in a New York Times best-seller written in 1982 by Tom Peters and Bob Waterman entitled In Search of Excellence. The criteria for excellence included average return on capital, average return on equity and compound asset and equity growth.
Using the same formula, Clayman identified the 29 worst stocks and called these the "unexcellent" companies. She then compared the investment return of the portfolios of the "excellent companies versus the unexcellent companies". From 1981 to 1985 the "unexcellent" companies outperformed the S&P 500 by 12%, while the "excellent" companies outperformed the S&P 500 by only 1%. The conclusion can be that the supposedly "unexcellent" companies are often so ignored by the market there is scope for strong returns when they do produce good financial results.
Another earlier study looking at value stocks was conducted by Paul Miller in 1964. Miller compared buying the 10 lowest and 10 highest price/earnings (P/E) stocks of the Dow 30 from July 1936 to June 1964. The P/E multiple is the price of the company divided by its earnings. A lower P/E is another definition of a value stock. He found the 10 lowest P/E stocks greatly outperformed the 10 highest; however, the lowest 10 P/E stocks also had a greater volatility of returns. This identified that returns for these stocks were more volatile, suggesting there was a greater "risk" in holding these shares.
In 1992, professors Gene Fama and Ken French published the paper the Cross-Section of Expected Stock Returns, in the Journal of Finance. This paper was the winner of the Smith-Breeden prize for the best paper in the magazine that year. The paper looked at returns for individual shares in the US sharemarket between 1963 and 1990. It found that:
� Small companies had a higher expected return that large companies.
� Value companies had a higher expected return than growth companies. The paper defined value companies as those with a low price to book ratio; that is; the share price of the company traded closer to the value of its assets than a growth company.
This group of evidence all suggested that value companies do have a higher expected return and therefore value is likely to be an area of the sharemarket that would make sense for people to invest in.
However, we must bring the discussion back to one of the fundamentals of investing, the trade-off between risk and return. For a company or group of companies to have higher expected returns going forward compared to the market average they must, by definition, be a riskier investment. These companies are out of favour for a reason due to current market conditions or company specific issues. A current example is the banking and finance sector. The sub-prime collapse and ensuing credit crunch has caused difficulties for these type of companies. Some have experienced extreme distress, take Bear Stearns in the US for an example. However the expectation is that through good management and a change in economic conditions the vast majority of these companies will pull through and in doing so outperform the market because they are coming from a lower base.
With this in mind it is important to make sure that a value approach investment is well diversified by investing in a range of different companies as well as being used in conjunction with investments in less riskier assets such as an index fund based on the top 100 or 200 companies in the ASX.
Scott Francis provides an analysis of one approach to value investing in one of his latest Eureka Report article - Can market 'dogs' outrun the rest. Well worth a read.
